With average GDP growth of around 9% between 1989 and 2022—as well as the world’s largest population—China came into its own as one of the world’s most exciting investment destinations over the past decade. Its runaway growth as the country slowly liberalised its economy and integrated it with the rest of the world, made it a formidable force.
Yet investors’ ardour towards China has soured in recent years. A harsh zero-Covid policy, the rise of President Xi Jinping and fears of a real-estate and infrastructure investment bubble have all given investors pause for thought. This is reflected in the poor performance of those indices and assets with large exposure to the Chinese market over the past year.
Even after rallying in late November and early December, the Shanghai Composite Index, the MSCI Dragon Index and the Hang Sang Index were down approximately 22%, 19% and 15%, respectively, (as measured in dollars) for 2022, although these numbers were in line with the negative returns of other major bourses. Given that China cannot be ignored because of its size and growth potential, many clients have asked whether current valuations of these indices present an attractive investment case.
We believe that the opportunities and risks of the Chinese market should be carefully evaluated before allocating a substantial percentage of one’s portfolio to this region. On the positive side, there are some encouraging prospects for economic recovery, as the centralized authorities finally seem to have pivoted away from an inflexible zero-Covid policy.
Is a recovery really on the cards?
This sets the scene for stronger economic growth in 2023. Fitch forecasts that growth in mainland China will recover partially to 4.1% in 2023, from 2.8% in 2022. This remains below pre-pandemic trends, but it also sets the scene for a bigger recovery in 2024 and beyond. There is therefore a case for optimism about the wider Chinese economy.
However, some scepticism exists in contrast to such optimism: Both Fitch and the Financial Times warn that the loosening of lockdowns and quarantine restrictions might not be as fast and comprehensive as some observers think. Low vaccination and immunity rates, a strained healthcare system and a vulnerable, elderly population mean that China may have to temper its re-opening strategy.
But even if the Covid situation is magically resolved, President Xi Jinping casts a long shadow over China as an investment destination. During the 20th Chinese Communist Party (CCP) National Congress last year, President Xi consolidated his iron grip on power. Furthermore, some of the pro-economic growth individuals central in the pre-Xi years were sidelined.
Inconsistent regulation and centralised control are concerns
Given the prevailing geopolitical tensions in the region, it presents a real challenge as to whether the ongoing tension between China and the West over the status of Taiwan, or various trade concerns, will boil over into open conflict. However, it does seem that China and its traditional partners such as the US are drifting further apart. There are also signals that China may be reversing direction from liberalization back towards a command-and-control economy.
This is reason for concern, given that President Xi appears to be largely indifferent to market signals and the concerns of investors. Xi has on several occasions displayed his willingness to send markets in China and the rest of the world into a spin as he exercises increased political control. We have already seen him tighten the screws on Big Tech, especially in markets such as education, ride-hailing and online gaming, with further news this week suggesting that the Chinese government will seek to own “Golden Shares” in Alibaba and Tencent.
In the absence of consistent regulation, investors are correct to worry about the safety of foreign capital in the world’s second-biggest economy. Without firm property rights and a transparent, stable regulatory regime, any asset or market will need to be priced for a higher level of risk. On balance, although Chinese companies are trading at historically low multiples, we are still not certain that the risks are sufficiently priced in.
All that said, China is deeply woven into the fabric of the global economy. Its status as the world’s manufacturing hub is unassailable and there are some Chinese companies that have either diversified into other markets, or that operate in structurally growing themes like healthcare, semi-conductors and renewable energy. Fund managers that follow a quality approach may see opportunities in those sectors and this is currently our preferred policy framework for clients seeking to increase their exposure to the world’s second largest economy which is under-represented in major global market indices.
